The Volcker Rule

Jeff  Carter
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Posted: May 13, 2012 12:01 AM

The Volcker Rule has been fought by banks ever since its proposal. If you checked out bank operations and their income statements, you would know why. Since the repeal of Glass-Steagall and the subsequent march of every bank to go public, their use of proprietary trading has increased.

No one can do it like a bank.

They can leverage their balance sheets and drive a lot of profitability through the company. In addition to being able to use leverage, they access the Fed window and public markets for cheap money. The cheaper weighted cost of capital for a bank versus a hedge fund gives the bank an edge no one else in the market has.

In addition, banks are the owners of dark pools, and deliberately try to make certain parts of the market place opaque. Corporate bond trading, muni bond trading, many areas of equity and forex trading are simply small private clubs that banks can take a cut on both the entry and exit via their prop trading desks.

The Volcker Rule sort of addresses that but it’s sloppy. The reason it’s sloppy is because the rule is being written by regulators and attorneys. Traders know the real score and spirit of the rule. The other reason the rule is sloppy is that banks have become so big, and the industry so murky that it’s pretty easy for them to justify any trade as a hedge that’s needed for them to conduct business.

Let’s try to simplify it.

Back in the late 1980's, there was a big conflict between independent traders (locals) and brokers at the Chicago Mercantile Exchange. Locals accused brokers of trading against their own customers, taking relatively little risk. The brokers were making money filling orders, and trading against them. In many cases, quid pro quo arrangements were worked out so order fillers simply traded with each other, lining each other’s pockets almost risk free. Sound familiar?

Not all brokers were guilty. In fact, most brokers weren’t. But upon doing a pit by pit survey it was found that many of the largest brokers were also the largest traders. Locals were steamed. They got together and won a change in the rules which still exist today. Rule 552. I think that CME’s rule 552 can be expounded upon to replace all the wishy washiness of the proposed Volcker rule. The rule has changed slightly throughout the years, and electronic trading makes a lot of it moot.

1. Dual Trading: The term “dual trading” shall mean trading or placing an order for one’s own account, an account in which one has a direct or indirect financial interest or an account which one controls, in any contract month in which such person previously executed, received or processed a customer order on the Exchange floor during the same Regular Trading Hours session.

2. Customer: The term “customer” means the ultimate (end) customer or originator of the order, not the clearing member.

3. Mature Liquid Contract: The term “mature liquid contract” means a contract month by position in relation to the front month contract at any given point in time that has had during the prior six calendar months an average daily pit-traded volume of 10,000 or more contracts; provided, however, that the Board of Directors may exempt from or include in this definition specific contracts and hours of trading during which such contracts will be deemed not to be mature liquid contracts, taking into account any market conditions which, in the Board’s opinion, would justify such action

The initial knock on the dual trading ban was that it would decrease liquidity in markets and increase costs. The data after the rule was imposed showed no liquidity loss, and no increase in the width of the bid/ask spread. I suspect the same thing will happen if banks stopped prop trading.

In essence, the spirit of any rule should follow this one guideline. Brokers should perform a service for their customer and represent them to the marketplace. The job of a broker is to fill the order in a timely manner at the best possible price they can get. They earn a commission for that service. The broker assumes relatively little risk.

The trader takes the opposite side of the order. They assume a lot of risk, and earn profit if the market moves their way. They are independent legally and financially from the broker.

We could call it the KISS system of financial regulation. Keep it simple stupid.

Banks would earn a lot less money. Drain trading profits off their top line revenue and they would be a shell of themselves. This is one reason they are fighting the Volcker rule. Bank traders would have to separate from the bank, and trade as independent traders. They wouldn’t be able to sniff and trade against the internal order flow of the bank, and they wouldn’t have a stranglehold on many marketplaces. Markets should be more transparent, because there will be a lot more independent traders in it, not banking monoliths.

Liquidity will be unaffected, bid/ask spreads will be unaffected, and we will get flatter more competitive marketplaces. That’s what we found back in 1991 when dual trading was banned on the floor. No reason why the same thing won’t happen if they ban it throughout all the capital markets.